Bad Weather and Expensive Bacon

Too bad we can’t apply limits to weather shocks!

Shoppers will have noticed some worrying changes to the cost of their groceries in recent months, with the prices of some supermarket favourites – coffee, orange juice, bacon – rising rapidly this year. But this might be just the start of a sustained increase in prices, at least for those commodities produced in countries that are subject to climate and/or geopolitical shocks.

The signs don’t look good, with the combination of an expected weather patterns, the developing Ukraine crisis and animal disease combining to reduce supply and push up prices.

It’s a far cry from just one year ago, when good weather conditions led to record production of corn in the US and wheat in Asia. The bumper harvests in 2013 caused prices in those crops to fall dramatically.

So what is happening now?

For one thing, weather forecasters are predicting an El Nino weather pattern later this year, which causes higher temperatures across the globe, increased rainfall in some countries and drought in others.

The effects can be dramatic. The last significant El Nino in 1997-98 cost approximately $3 billion dollars in agricultural damage in the US, according to an analysis conducted by Texas A&M University. As the Financial Times notes, anew El Nino would likely lead to price increases in coffee, sugar, cocoa and orange juice due to expected droughts in Brazil and West Africa. However, cereals could be affected too, pushing up the cost of animal feed and therefore the price of meat.

That’s on top of the current crisis in Ukraine, which could force the price of wheat up, as well as disrupt natural gas supplies.

Meanwhile, a mysterious virus is killing pigs in the US, which will have a significant impact on pork prices.

A similar mix of events has occurred in the past, most notably in the mid-eighteenth century, when a mini ice age in Europe combined with epidemics and the disastrous seven years’ war (the very first in history that took the form of a global conflict covering Europe, partially Asia and Canada) led European countries to famine and a deep economic and social crisis.

Fortunately, this isn’t the eighteenth century, and commodity producers, suppliers and end-users can use commodity derivatives and other capital markets instruments to mitigate climatic and geopolitical shocks. A liquid and efficient commodity derivatives market may prove critical in helping participants to hedge their exposures to high commodity prices in 2014.

No doubt, some commentators will look at the price rises, and point the finger at financial investors using derivatives as a means of gaining exposure to commodities and generating returns. It may even give greater impetus to the push for position limits.

It’s true there may be investor activity in agricultural derivatives, but it’s not obvious position limits will prevent the rise in prices, given they are being driven by fundamental factors. In fact, limiting the size and liquidity of any market is unlikely to reduce volatility.

Applying limits to climatic shocks or geopolitical shocks is unfortunately not possible…too bad.